The First Year of the Eurosystem: Ination Targeting or Not?

This paper is a brief evaluation of the Eurosystem's monetary-policy regime after its first year, in particular of the extent to which it is similar to inflation targeting as practiced by an increasing number of central banks. I examine the Eurosystem's goals, framework for monetary-policy decisions and communication with outsiders. Criteria for evaluation are whether the goals are unambiguous and appropriate; whether the decision framework is efficient in collecting and processing information and reaching decisions that are appropriate relative to the goals; and whether the communication is effective in motivating decisions, simplifying external evaluation and thereby improving transparency and accountability. I also consider whether the actual instrument setting has been appropriate, given the information available at the times of decision. JEL Classification: E42, E52, E58 Keywords: Monetary targeting, ECB, transparency AEA.tex Byline: First Year of the Eurosystem The First Year of the Eurosystem: In‡ation Targeting or Not? Lars E.O. Svensson* January 2000 On January 1, 1999, the Euro was launched and the Eurosystem (the ECB and 11 national central banks in Europe) took responsibility for monetary policy in the Euro area. This paper is a brief evaluation of the Eurosystem’s monetary-policy regime after its …rst year, in particular of the extent to which it is similar to in‡ation targeting as practiced by an increasing number of central banks. I examine three elements of the Eurosystem, namely the goals, the framework for monetary-policy decisions and the communication with outsiders. Criteria for evaluation are whether the goals are unambiguous and appropriate; whether the decision framework is e¢cient in collecting and processing information and reaching decisions that are appropriate relative to the goals; and whether the communication is e¤ective in motivating decisions, simplifying external evaluation and thereby improving transparency and accountability. I also consider whether the actual instrument setting has been appropriate, given the information available at the times of decision. During the 1990s an increasing number of central banks have adopted in‡ation targeting, which due to its logical and transparent design and apparent success so far has become a focus of interest and a natural frame of reference. In‡ation targeting is characterized by, …rst, an explicit numerical in‡ation target. The in‡ation target is pursued in the medium run, with due concern for avoiding real instability, for instance, in the output-gap; that is, in‡ation targeting is “‡exible” rather than “strict.” Second, due to the unavoidable lags in the e¤ects of instruments on in‡ation, the decision framework is in practice “in‡ation-forecast targeting” (see below). Third, communication is very explicit and to the point; policy decisions are consistently motivated with reference to published in‡ation and output(-gap) forecasts. Indeed, in‡ation targeting has introduced unprecedented transparency and accountability in monetary policy. Three central banks—the Reserve Bank of New Zealand, the Bank of England, and Sweden’s Sveriges Riksbank— stand out as particularly consistent and transparent in their implementation of in‡ation targeting. I. Goals The Maastricht Treaty assigns price stability as the primary objective for the Eurosystem but leaves to the Eurosystem the formulation of an operational de…nition. In October 1998 the Eurosystem de…ned price stability as “as a year-on-year increase in the Harmonised Index of Consumer Prices for the euro area of below 2%” (ECB 1998a). It has several times emphasized the medium-term orientation of its policy and that a gradualist and measured response to threats to price stability will not introduce “unnecessary and possibly self-sustaining uncertainty into short-term interest rates or the real economy...” (ECB 1999). This emphasis on the medium term, gradualism, and stability of the real economy is consistent with “‡exible” rather than “strict” in‡ation targeting. However, as commentators quickly pointed out, the Eurosystem’s de…nition of price stability was ambiguous, since it did not specify a lower bound for in‡ation. In November 1998 the ECB president, Willem Duisenberg (1998a), clari…ed that the word “increase” should be interpreted as excluding de‡ation. It would seem to follow that the lower bound was zero and that the de…nition refers to an in‡ation rate between 0 and 2%. However, two days later, Duisenberg (1998b) stated that “[w]e did not announce a ‡oor for in‡ation, because we know that the price index may include a measurement bias, but we do not know its magnitude”. If the lower bound is zero, it would seem logical to use the midpoint, 1%, as the point in‡ation target in the calculation of the M3 reference value. However, when the reference value was announced in December 1998 (ECB 1998b), it appeared that a point in‡ation target of 1.5% had been used instead. To this date (January 2000), so far as I know, the Eurosystem has not yet been explicit about the lower bound. If this omission were due to uncertainty about possible measurement bias, it would seem that this would a¤ect both the lower and upper bound to the same extent; otherwise, the width of the range becomes dependent on the measurement bias. It is di¢cult to see any bene…t from such ambiguity. An unambiguous